Investment Workshop 33: Why Accredited Investors Keep Getting Scammed

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.

For some strange reason, despite the fact that all I do is harp about passive, low-cost ETFs, I keep getting questions over emails like this one:

I recently found out about an investment fund that’s really interesting. They buy up ponies, implant horns on their heads and then resell them as unicorns (Wanderer: I just made that up as an example, but I could TOTALLY see that working as a business. Patent pending, bitches). However, it’s only open to accredited investors. Is this a good idea?

And after a few “well DUH NO, stupid!” replies, I started to realize why pitches like this are so attractive. It’s something I like to call the Red Velvet Rope Phenomenon.

Imagine this. A door, just an unassuming metal door, on the side of a nondescript grey building you see on your way to work everyday. You see it, but you don’t think about it, you don’t care about it, you don’t remember it.

Now put a red velvet rope and a bouncer in front of it.

Now, that door is mysterious. Desirable. Only important people get to go through there, right?

And that, right there, is the Red Velvet Rope Phenomenon.

By limiting access, you create exclusivity. And by creating exclusivity, you create the Illusion of Quality.

Let me back up for a minute.

Accredited investors is a term used both in Canada and the USA, and is generally defined as:

An individual who, either alone or with a spouse, beneficially owns financial assets having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1,000,000; or

An individual whose net income before taxes exceeded $200,000 in each of the two most recent calendar years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the two most recent calendar years.

In other words, a rich person.

And for this reason, it’s assumed that an Accredited Investor (aka, a rich person) can stand to lose a couple hundreds of thousands of dollars. After all, they’re rich, right? If they get scammed, fuck ’em. What’s $100k to a millionaire? They’re rich!

Here’s the problem.

In both Canada and the USA, certifying yourself as an Accredited Investor requires absolutely ZERO verification. Anyone walking off the street with a nice suit can fill out a disclosure form and claim they’re an accredited investor.

Who’s THEM? Scammers. Only these scammers are dressed in thousand-dollar suits.

Government regulations in both countries are designed, theoretically, to protect investors. Normally mutual funds and ETFs are required to publish prospectuses, report performance statistics, and, generally, disclose what the bloody Hell they’re doing behind the scenes. Exempt investments, however, aren’t required to report any of this. And guess what? Only accredited investors are allowed to invest in Exempt Investments.

The well-meaning rationale behind this is that there are certain funds that execute these weird and crazy strategies involving options and derivatives and whatever black magic makes that particular fund work, and they don’t want to disclose it to the SEC. And that makes the fund inherently riskier because it makes the fund opaque. You have no bloody idea what they’re doing behind the scenes. They could be making crazy bets and you’d have no idea! And that’s kinda the entire point.

But an exempt investment is allowed to exist knowing that it’s inherently riskier under the assumption that it’s only allowed for Accredited Investors. The rationale goes that since they have so much money, they know what they’re doing so they government doesn’t need to keep such a close watch on what they invest in.

And if this is starting to sound like the land where scams are born, you’re right.

What scammers do is they start funds that invest in weird or esoteric things, or claim to have some kind of secret investment strategy that will make investors double-digit returns each and every year. Any financial regulator would stop them from making such a wild and outrageous claim, but by only making the investment open to Accredited Investors, they’re exempt from the reporting requirements most mutual funds and ETFs are subject to.

And again, there is ZERO validation that happens when an investor declares themselves Accredited Investors. Any idiot can claim they’re a millionaire. But if you do declare yourself as Accredited, and you invest your life savings in some sketchy investment that then collapses, the people who lost all your money can claim that since you lied and declared yourself Accredited, you can’t sue them for losses.

But the allure of investing in something only millionaires invest in is so strong that it works over and over again. Because of the Red Velvet Rope Phenomenon.

Normally, only rich people have access to these kinds of “special” investments. But I can let you in if you sign this form…

There’s this strange idea I keep running into that rich people are somehow “better” than regular people. That they belong to secret clubs and gather in secret meetings and have access to secret investments, and that’s why they became rich. And while I freely admit that the first 2 points are kinda sorta true (see here), all the rich people I know didn’t get there using any “secret” methods. Mr. Money Mustache, Jim Collins, MadFientistJeremy & Winnie, and Justin McCurry became millionaires by saving their salaries year after year and investing it in low-cost Index-hugging ETFs that are available to anyone with a brokerage account. Others, like Paula Pant, used real-estate investing or built businesses and became rich that way. But I know of precisely ZERO rich people who became rich via hedge funds. ZERO.

And yet there’s this idea that rich people have some kind of secret handshake that allowed them to become so rich. And this is the idea that scammers sell. And again, it works.

Here in Canada, the investment world got rocked recently by the collapse of First Leaside, an investment firm that promised double-digit returns on real estate investments, but only to…you guessed it, Accredited Investors.

And in America, the largest Ponzi scheme ever was perpetrated using this method by none other than Bernie Madoff.

So to all those that email us asking “should I invest in this thing that’s only open to Accredited Investors?” the answer is FUCK NO.

And that’s why we don’t invest, and never will invest, in any of those things in our personal portfolio, or in this workshop.

Canadian Portfolio

We begin our regularly scheduled buys as we always do, by taking a snapshot of our current portfolio allocations…

Asset

Ticker

Unit Price

Units

Market Value

Allocation

Target Allocation

Canadian Bonds

VAB

$25.73

112

$2,881.76

37.79%

40%

Canadian Index

VCN

$30.87

46

$1,420.02

18.62%

20%

US Index

VUN

$44.34

32

$1,418.88

18.61%

20%

EAFE Index

XEF

$29.48

38

$1,120.24

14.69%

16%

Emerging Markets

XEC

$25.49

11

$280.39

3.68%

4%

Cash

–

$1.00

504.35

$504.35

6.61%

0%

We then calculate what we need to do to restore our target allocations…

Asset

Ticker

Target Allocation

Unit Price

Current Market Value

Target Market Value

Current Units

Target Units

Difference

Canadian Bonds

VAB

40%

$25.73

$2,881.76

$3,050.26

112

118.5

6.5

Canadian Index

VCN

20%

$30.87

$1,420.02

$1,525.13

46

49.4

3.4

US Index

VUN

20%

$44.34

$1,418.88

$1,525.13

32

34.4

2.4

EAFE Index

XEF

16%

$29.48

$1,120.24

$1,220.10

38

41.4

3.4

Emerging Markets

XEC

4%

$25.49

$280.39

$305.03

11

12.0

1.0

Cash

–

0%

$1.00

$504.35

$0.00

504.35

0.0

-504.4

And finally, we decide on our buy orders being careful not to go into margin…

Asset

Ticker

Unit Price

Action

Fractional Units

Units

Proceeds

Canadian Bonds

VAB

$25.73

BUY

6.5

7

$180.11

Canadian Index

VCN

$30.87

BUY

3.4

3

$92.61

US Index

VUN

$44.34

BUY

2.4

2

$88.68

EAFE Index

XEF

$29.48

BUY

3.4

3

$88.44

Emerging Markets

XEC

$25.49

BUY

1.0

1

$25.49

Total

$475.33

American Portfolio

And on our American side, we do the same…

Asset

Ticker

Unit Price

Units

Market Value

Allocation

Target Allocation

Bonds

BND

$82.00

35

$2,870.00

36.84%

40%

US Index

VTI

$124.65

17

$2,119.05

27.20%

30%

International Index

VEU

$50.22

44

$2,209.68

28.37%

30%

Cash

–

$1.00

590.71

$590.71

7.58%

0%

We figure out how to rebalance back to our target allocation…

Asset

Ticker

Target Allocation

Unit Price

Current Market Value

Target Market Value

Current Units

Target Units

Difference

Bonds

BND

40%

$82.00

$2,870.00

$3,115.78

35

38.0

3.0

US Index

VTI

30%

$124.65

$2,119.05

$2,336.83

17

18.7

1.7

International Index

VEU

30%

$50.22

$2,209.68

$2,336.83

44

46.5

2.5

Cash

–

0%

$1.00

$590.71

$0.00

590.71

0.0

-590.7

And finally we decide on our unit orders. Again, the high unit prices of the American ETFs caused me to make some irritating rounding decisions…

Asset

Ticker

Unit Price

Action

Fractional Units

Units

Proceeds

Bonds

BND

$82.00

BUY

3.0

2

$164.00

US Index

VTI

$124.65

BUY

1.7

2

$249.30

International Index

VEU

$50.22

BUY

2.5

2

$100.44

Total

$513.74

And with that, we’re done. Thanks everyone, and see you next week!

WORKSHOP TOOLS

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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.

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Great post! When you really dig into the fee structure & mark to market valuations, that’s where the real scam is… Not to mention the 400 page Limited Partner Agreement or Private Placement Memorandum that you sign in which you basically sign your balls (ovaries) away.

I find this very interesting, and I’m wondering, do you really think that EVERYTHING available only to accredited investors is bad? They all branch out far from the index portfolio approach, but things like Copower (green bonds) are considered a private placement, and while middle income people can invest, Accredited Investors are able to invest more). Also Venture Capital Funds (which I realize are very risky, but some have also had some pretty staggering returns when the startups they invested in got bought). Also some pretty large and successful mutual funds that are not hedge funds (can’t remember what they are from memory). I think a blanket approach saying that “absolutely everything that is only available to accredited investors is bad” isn’t at all accurate. Saying they are higher risk IS accurate, and that there is more likelihood of scams is probably true (do your due diligence and avoid things that appear too good to be true), and I agree that hedge funds are not the way to make money. But I think there are probably a lot of of investments out there only available to accredited investors that are legitimate, and are up front about what they are. And some of them can pay off with a higher return in some cases (but obviously should be a small portion of a portfolio due to the risk, and the investor should do their due diligence). Thoughts?

I’m pretty sure FC wasn’t implying anything that can only be accessed by accredited investors is inherently bad. Her main points are accurate. Hedge funds, PE funds, Angel investments are all generally more risky, less transparent and come with higher costs. I’ve been investing some mad money for the last 4 years in angel investments and PE funds. I support the local startup ecosystem in my city knowing that 8 or 9 out of 10 of these companies will most likely fail. The key is to spread your money around but be willing to make 15-20 small company investments because it only takes 1 winner to cover your bets and make a big profit but it is very hard to find that one in the haystack that is going to succeed so you have to increase your odds by spreading around your bets. These investments are not for the faint of heart but good entrepreneurs need support and a chance to succeed and it all starts with someone willing to give them a chance.

PE funds also have less transparency but more chance for success. Many well-heeled pension funds, university endowments, large family offices, etc. invest in these vehicles. Generally, these funds have massive research capabilities and some of the smartest people investing the money. Fees are stiff which is why they also focus on your Net IRR. Their pitch is “do you really care how much I made if I’m giving you a double-digit return every year?” The challenge here is you have to commit funds for 5-10 years and probably file an extension every year when you do your taxes because their K-1 documents almost never come in time to file during the normal filing period. You also have to be familiar and comfortable with the J-curve. This means while they are investing your money into things that are not initially making any money, the value of your investments and statements will show a significant paper loss. As their investments start to perform over time the trend reverses, usually fairly dramatically and a sudden turnaround equals a corresponding reversal of fortune in your monthly statement. Hence, the curve is a series of steady drops followed by a quick, steep rise in value as the investments they have made on your behalf start to payoff.

In summary, investment opportunities only available to accredited investors should be reserved for folks who understand and accept the risks/costs/terms and who are willing to take a higher chance of loss of principal for the opportunity to receive a higher than average rate of return.

If you are rich you’ll always have moochers and leechers. Look at all the celebrities who were conned outta their money. and don’t get me started on pro athletes who got swindled.
Why bother with those investments when you got the S & P 500 or any number of public equities.

Warren Buffett said he’d put most of his $ there and a small portion in cash when he passes away. If that’s good enough for the 2nd richest man it’s good enough for me.

No, not every exempt investment is “bad.” I’m sure the angel investors who invested in Apple when they were just starting out is doing just fine. But those investors could have also seen their investment go down to 0 just as easily.

Exempt investments are gambling, plain and simple. You’re betting on a horse race. And if you limit your exposure to these things to < 5% of your net worth, you won't blow yourself up too badly. But if you're trying to retire or get rich with these things, you're in for a world of hurt.

Ick. For our workshop we do buys/rebalancing every 2 weeks, but that’s because we picked a brokerage that offers free ETF purchases.
For you, I’d suggest doing it once, maybe twice a year at most to keep your fees low. Or find a better brokerage 🙂

A bit off topic but I was wondering about your thoughts on de-population and how it will impact investments in the future. According to http://www.zerohedge.com/news/2017-06-26/end-growing-consumer-base-and-beginning-decline the populations in consumer based nations will begin declining in 2018. Does this mean there will be endless cycles of recessions and depressions in the future? We are always told that new immigrants are needed to sustain growth. Well… if overall populations decline everywhere, doesn’t that spell problems?

I’d agree with the idea that immigration is necessary to maintain and grow the economy. Japan’s population has been stagnant for some time, it’s difficult to immigrate, and as a result their economy’s been stuck for a decade. Canada and the US have avoided that because of their openness to immigration (though that may change in the US with the current administration)

However, I’m not convinced that worldwide populations are declining. If that were true, then yes that would have bad for the economy but I’m not convinced it is.

For the past 15 years or so, Generation X has been the segment of the U.S. population in its peak earning years (35-50). These are the ones that drive the economy – new cars, bigger homes, restaurant meals, buying clothing for themselves and their kids, etc. There are ~65 million members of this group.

We’ve got millions more Millennials than Gen-Xers, though, and the oldest Millennials just turned 35 last year. In other words, 75-80 million Millenials are about to enter the peak earning years, while only 65 million Gen-Xers drop out.

Interesting topic you bring up about accredited investing as I had a silly thought not too long ago. I currently work for a well known family investment office that lets its employees invest in the family’s investment funds for a significantly reduced buy-in amount based on financial asset totals. Normally it’s a million for family members and/or friends (similar to what you said in your post)…I think for employees it’s $100K-200K. I guess it sort of makes sense since it gives employees “skin in the game” so to say, similar to a employee stock purchase plan. I’ll be honest, I thought about it because it sounded sexy to be associated with this family name. However, once I realized that after management and “investment advisory” fees that it gives similar market returns (for now) to what I could get from a normal index fund/ETF, the choice was clearly a FUCK NO. The Red Velvet Rope Phenomenon is a real thing Wanderer 🙂

Danny, you are correct in that if your Family Office investments are only generating market returns at higher fees and more risk then, of course, stay away! The majority of Angel and Private Equity investments are not investing for just market returns. In general, Angels are looking for an exit that has an objective to return at least 10X your original investment and Private Equity generally looks at net returns (after expenses and commissions) of 2X-3X what the market is giving you in other investments.

Again, this comes with all the caveats I highlighted in my earlier comments. This is also about diversification and taking a small portion of your portfolio and shooting for these above average returns with money that may be currently generating lower returns. For me, I used a portion of savings bonds for my PE & Angel investments which were generating about 1.5% so I felt the potential for these above average returns justified the risk I was taking.

There is an element of truth to Red Velvet Rope phenom no doubt, but I think Wanderer paints with too broad a brush. There are definitely risky and weird private equity investments out there (hedge funds, marijuana cultivation, hydroponic farms, ATM machines, NBA player contracts) but there are also many many legit investments that generate way above market returns. Now most of these are not appropriate for the average DYI investor. But if you qualify and put in the education and due diligence, these can be very appropriate investments as PART of a well diversified portfolio. I’m personally invested in hard money lending, apartment buildings, industrial flex warehouses, retail, office buildings, brand name hotels (Holiday Inn, Hiltons), self storage facilities, mobile home parks. These all require accredited investor status. Yes these are illiquid w/ 3-10 year holds and you do have to trust the sponsor to execute the plan, but the payoff is in the range of 15-30% IRR. I know plenty of investors getting wealthy through accredited investor instruments. Due diligence and vetting is key.